Is There Alpha in Private Assets?

July 7, 2016

Is There Alpha in Private Assets? Photo

While the market volatility-buffering benefits of private equity are well known, advocates of the investment vehicle have also long argued that private equity-backed companies tend to perform better than their publicly-traded counterparts. This advantage stems not only from financial engineering but also from stronger operational performance. These benefits are measurable in aggregate through the relative investment performance of private equity versus the appropriate public market proxy. To be meaningful, a comparison of the return streams of private equity and its benchmark must be calculated in a similar fashion, making comparison difficult using conventional private and public performance metrics.

The modified public market equivalent (mPME) is one way to make an apples-to-apples comparison. Modified public market equivalent is a private-to-public comparison that evaluates what returns would have been earned had the dollars been deployed in the public markets instead of in private investments. The measure assists investors in determining whether the returns from private investments are worth the illiquidity and administrative burden incurred. It also serves as a way to isolate and compare the relative earning power of private equity assets, rather than allowing these assets to benefit from or be penalized by cash flow timing differences versus its public market benchmark. (Public market benchmarks are typically calculated assuming that assets are fully invested on day one, while private equity is subject to capital calls over a fund’s investment period.) This week’s chart illustrates the performance of the Cambridge U.S. Private Equity Index versus that of the S&P 500 Index’s mPME between 1986 and 2014.

What is clear from the data is that private equity consistently outperformed the the S&P 500 Index’s mPME over the examined vintage year range. In fact, over the 29 years examined, the private equity index outperformed the S&P 500 mPME over 22 vintage years, while the S&P 500 mPME outperformed the private equity index in seven. Four of the seven vintage years where the S&P 500 mPME outperformed are still within the investment periods of the funds represented in the Cambridge benchmark, so they’re either in, or just coming out of, their j-curves. Over the entire period examined, private equity outperformed the S&P 500 mPME by nearly 450 basis points annually, on average.

Key Takeaway:

While there is return volatility between vintage years, from an absolute and relative basis, private equity has regularly outperformed public assets over the last 29 years. At 400+ basis points per year, on average, this outperformance was quite impactful. Because it is impossible to know which future vintage years will outperform their public market benchmarks, the strength of the historical outperformance suggests private equity should be considered as a long-term allocation within a diversified investment portfolio.

Tags: Chart of the Week | S&P 500 | Private equity | mPME

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This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.  This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.

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